November 12, 2008

There's an important lesson in the current economic crisis that hardly anyone's talking about: income inequality as a cause.

There have been two periods of extreme income inequality in the US: 1) just before the Great Depression, and 2) right now. People acknowledge that, but almost nobody draws the obvious conclusion.

How would extreme income inequality have fed the current crisis and soon-to-be depression?

Most Americans have seen their inflation-adjusted incomes stagnate or fall over the last couple of decades. What has been the result? Consumption by average Americans is the engine that drives the American — and much of the world — economy. It accounts for 70% of US GDP. Falling income ordinarily means falling consumption, which means a slowing economy. To forestall that outcome, Americans were deluged with easy credit. They made up for the shrinkage in their incomes by borrowing, largely in the form of home equity loans and credit card debt. But now that's over. Falling home prices have taken home equity loans off the table. And I don't know about you, but I used to get a pre-approved credit card offer in the mail just about every day. No more. Easy credit is gone, so now the economy's being hit all at once, rather than gradually, with the consequences of the reduction in the average person's income. Nobody's shopping. The result will be a self-reinforcing spiral that's really only just getting underway. Less consumption will lead to layoffs, bankruptcies, etc., which will lead to even less consumption, and so on.

Meanwhile, incomes soared for the people at the top. Since there's a limit to how much stuff people can buy, all that concentrated wealth went looking for places to invest. Interest rates were low (feeding the rest of us with easy credit) so it didn't pay to stick one's money in things like Treasury bills. And with their incomes growing at a giddy pace, people at the top felt impervious to risk. Enter the mortgage-backed securities, CDOs, CDSs, etc., etc.

In a more equitable society, the average person's income would have been growing all along and there wouldn't be such a giant pool of money at the top. Average people wouldn't have needed to take on enormous amounts of debt to see an improvement in their standard of living. The well-to-do wouldn't be drowning in cash and feeling like risk couldn't touch them. No bubble, no bubble bursting.

The irony is that American capitalism has cut its own throat. By hogging the spoils, the rich created a situation where the very system that supports them is in jeopardy. A more equitable society is a more sustainable society.